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You know the margin has to cover a lot more than you and your employees’ salaries. Everything your business does, all the money it spends, from utilities to credit card processing, comes from that sliver of income. It’s vital to understand exactly what your costs and expenses are (yes, all of them) so you can create a sustainable, thriving business.
You need to look through all of the products and services you sell, calculating margins and cost. Fortunately, it’s not as difficult as it sounds. In this guide to understanding margins, we’ll provide the formulas and go over the components for calculating margin in your business.
Definitions
So that we’ll all on the same page, let’s first define some common terms used when discussing margin.
Cost of Goods Sold (COGS): The cost of goods sold refers to the costs involved in making the product, including both materials and labor. COGS is used in determining gross margins. This is the cost that you pay for the item you’re going to resell to consumers.
Gross: The term “gross” refers to an amount of money you’ve collected before expenses (like cost of goods) are deducted.
Net: The term “net” refers to the amount of money left after all expenses are deducted from the gross amount. It’s what your business actually gets as profit.
Revenue: The total amount of money taken in by your business. This is used in many calculations, and for some businesses is the same thing as total sales. (Revenue and sales may not be the same thing for businesses that have alternative income streams, such as investments.)
Margin: Expressed as a percentage, the term “margin” refers to the difference between gross and net values.
Understanding Margins
Profit margin is essentially the difference between sales and costs. It’s a key component for measuring profitability in business and understanding what you can expect to make when you sell particular goods or services. If your margins aren’t large enough to sustain your business, it will be hard to grow and thrive. If your margins are too large, customers may think you’re overpriced and look for lower cost competitors. Finding the sweet spot is key to a sustainable business.
You can calculate margin on gross and net value, depending on what information you’re looking for. Gross margin is the difference between the selling cost and the wholesale cost of an item or service, but doesn’t take into account other expenses and therefore doesn’t give an accurate picture of how much money you’ve made as profit. Net profit margin is the percentage of revenue that you actually end up with; it’s what’s left over after all expenses have been taken into account and subtracted from the gross revenue.
Formulas
The formula for calculating your gross margin is:
Revenue – COGS / Revenue x 100
For example, if your total revenue is $10,000 and your cost of goods sold was $5,000, your gross margin is 50%. (10000 – 5000 / 10000 * 100.) This doesn’t take expenses into account, but gives you the gross margin.
The formula for calculating your net margin is:
Net Profit / Revenue x 100
For example, if your net income is $3,000 from revenue of $10,000, your net margin is 30%. (3000 / 10000 x 100). To find your net profit, you’ll need to do a little more math. Net profit can be found using the formula:
Gross Profit – Expenses / Gross Profit
Note that margins are expressed in percentages, while profits are expressed in dollars. So gross margin in the first example is 50% while gross profit is $5,000. The terms are sometimes used interchangeably, but for the purposes of this article, we’ll refer to margin for calculating percentage margins, not dollar values.
You can also calculate margin on individual items, using the following formula:
Item Sale Price – COGS – Aggregate Cost Per Item
For example, if you sell an item for $10 that cost you $5 and another $2 in aggregate costs, your net profit is $3 or 30% margin. (10 – 5 – 2 = 3). Let’s take a look at what those components mean in more detail and learn how to use the margin formula in your business.
Initial Item Cost: The Cost of the Product or Service Itself
This is probably your largest cost. It’s essentially the price you pay to buy or manufacture goods, or to provide a service. For products, it’s the amount you pay a supplier or wholesaler. For services, it’s the cost of actually providing the service – mainly the cost of paying the salary of the person doing the work.
Aggregate Costs: What They Are and What They Mean
The remaining costs are “aggregate” costs, meaning you can’t directly assign them to a specific item. They’re costs your business incurs as a whole. To work out the impact on your margins, you’d calculate the total cost and divide it by the number of items you’ve sold. If you want to be more sophisticated, you can start categorizing items by their impact on your costs, but for now we’ll keep things simple. Here are common aggregate costs:
Customer Service and Marketing
Customer Service and HR — This is the total amount you spend on customer service staff, operations, and tools to help your customers. Remember that when you’re looking at salaries, it’s not just gross pay. It’s also employer insurance/tax, healthcare, retirement plans, vacation, and any other benefits you provide.
Sales and Marketing — This is your cost of finding new customers. This could be advertising, paying your sales staff, hiring a marketing agency, and more.
Operations and Logistics
Logistics and Shipping — This is the cost of receiving the items in the first place, charged by the supplier or the shipper directly.
Refunds, Repairs, and Returns — The cost of replacing and fixing unsatisfactory items or refunding dissatisfied customers. Use your records to calculate how much you’re spending on this.
Operations — This is where your “miscellaneous” costs come in. It’s everything from the cost of providing workstations for employees, to web development costs, office rental, service subscriptions, and utility bills. It can be surprising just how much operational cost there is in a business, and many business owners overlook some of these costs.
Financial
Credit Card Processing and Transaction Costs — Another “hidden” cost, your transaction costs are how much it actually costs you to take payment. This includes credit card payment processing fees, cash handling/armored car pickup fees, chargebacks, and any other costs associated with accepting payments from customers. Credit card processing can be a huge component of aggregate costs, and it’s important to ensure that you have competitive pricing so that you don’t need to inflate the costs of your goods or services.
In fact, you may even gain a competitive advantage by securing lower cost credit card processing. If your competitor pays 1%-2% more than you do every time a customer uses a credit card, their prices will be higher to account for it, or they’ll make less money and not have as much financial flexibility as your business. An independent processing expert like CardFellow can help you compare credit card processors and choose the best option.
Tax — You’ll pay contributions on what you pay your staff, and tax on any profit your business makes. Some businesses that do their own taxes may also be leaving money on the table because of credit card processing fees paid on sales tax.
Other — This is a catch-all category for anything that’s not covered above. Once you’ve been through each of the areas above and worked out your costs, look at your financial reports to find any gaps that may go into your “other” costs.
Using Aggregate Costs
Add together all of your aggregate costs and divide by the total number of items you’ve sold. That will give you an average cost per item.
Now that you know your margin on an item, you can understand which items are driving more profit for your business and focus on providing those. It will also give you plenty of insight into your sales prices — Are they about right, or do you need to adjust them?
This is also a great way of understanding where there are inefficiencies in your business and making changes to reduce your costs and enhance your profits.
Margins Over Time
An important thing to remember is that costs don’t remain steady. Everything from changes in gas prices to shortages on raw materials can affect the cost of shipping, wholesale prices on goods, and more. Fluctuating credit card processing costs, changes in health insurance, and new employee salaries can also affect your margins.
It’s a good idea to have policies in place to ensure your costs are updated as necessary to ensure you have a healthy margin and continue to profit. If your costs go up and you don’t adjust your pricing, you could soon find yourself selling goods or services at a loss.
Increase Your Bottom Line
Every business wants to increase the bottom line. An alternative to raising prices is to lower your own costs, whether they’re the wholesale costs you pay for items, or business expenses. A major area where many businesses overpay is credit card processing or merchant services. At CardFellow, businesses save an average of 40% on credit card processing costs. Reducing your credit card processing fees can drastically improve your bottom line and keep your margins healthy without raising prices on your customers. Just want to look? Use our free quote comparison tool. It takes less than 3 minutes to give the info needed, and there’s no obligation. Try it now.
Formula Reference
For quick reference, here are the formulas used in this guide:
Gross Margin = Revenue – COGS / Revenue x 100
Net Margin = Net Profit / Revenue x 100
Net Profit = Revenue – Expenses / Revenue
Item Margin = Item Sale Price – COGS – Aggregate Cost Per Item x 100
Resources
Margin Calculator
CardFellow Credit Card Processing Quote Comparison Tool
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Paul Maplesden contributed to this article.
